Hewlett-Packard Company (HPQ): A Company To Keep Your Eye On

Tyler Laundon: The age of the conglomerate may officially be over. Companies are spinning off business units at a pace averaging one a week. And investors are loving it.

The most timely example is PayPal (NASDAQ: PYPL), which was just spun off from eBay (NASDAQ: EBAY) into an electronic payments powerhouse. But this is just one of many examples.

Many others are doing the same, and U.S. corporate spinoffs are near record highs. Last year 60 U.S. spinoffs were completed. That makes 2014 the biggest year for spinoffs since 1999 and 2000, when an astounding 66 were completed in each year. In 2015 it’s likely that over 50 spinoffs will occur.

From what I see, the resulting companies are often very attractive investments. Some may say this is just financial voodoo, but I beg to differ.

I like to gain diversification by owning companies that are really good at what they do, and not by owning a few companies that have a lot of disparate business units. I also hate to see a valuable business handcuffed within the cell of a large, lumbering organization.

The fact is that it’s now far easier for individual investors to gain diversification, with low transaction fees, by buying shares of individual stocks rather than conglomerates. And companies with more pure business models are generating extremely attractive returns.

Just look at the performance of the Guggenheim Spin-Off ETF (NYSEARCA:CSD). The ETF is designed around the spinoff event and is rebalanced semiannually, only including companies that were spun off six to 30 months prior to the rebalance date.

The performance of this ETF has been extremely good. Over the last five-year and three-year periods it has risen 148% and 74%, respectively, as compared to 98% and 54%, respectively, for the S&P 500. Year-to-date, both the CSD and the S&P 500 are up between 2% and 3%.

A Massive Split Comes in November

One of the biggest corporate splits in recent history will occur on Nov. 1. That’s the date that Hewlett-Packard (NYSE: HPQ) will split into two relatively equal-sized companies. One, HP Inc., will focus on printers, PCs and expanding into 3D printers, all while returning cash to shareholders and carrying more debt.

The other, HP Enterprise, will focus on growth markets such as enterprise and cloud computing. Shareholders that own HP going into the split will wind up owning both, if they do nothing.

With the stock moving in the wrong direction, I suspect many investors are wondering why they should bother holding (or buying) HP. I’m hoping that I can shed some light on my perspective, and why I think there is as much as 50% upside in the stock over the next year.

And long term, especially given the typical performance of companies post-split, I see much more upside. I should also mention that I’m long HP.

First, let’s look at the chart. There’s no sugarcoating this one – the stock just doesn’t look great at the moment. It’s recently breached both its 50-day (blue line) and 200-day (red line) moving averages. And it’s in a sort of no man’s land at the moment.

But be that as it may, there is still hope. The split should catalyze many events that could lead to outperformance in coming years.

The Wall Street Journal put together a nice graphic that shows what the company will look like after the split. As you can see in the image below, the two companies will have very close revenue and profit profiles.

So why bother buying now? Why not just wait until after the company split and buy whichever company appears to be doing better? Or just stay away until the stock performance improves?

Those are valid questions. But I think there is reason to move now, and potentially add more post-split – and not sell if you’re already long HP.

The bottom line is that shares of HP are cheap, trading at just 8 times forward earnings. That may be reason enough for value investors. But growth investors should be interested in the name, too.

Ripe for M&A

I expect HP will be aggressive on the M&A front after the split. It’s not practical for major acquisitions before the big day. And given relatively slow growth in both businesses (if not contraction) over the last couple of years, it only makes sense that HP will go out and buy some growth.

On the HP Inc. side there is massive 3D printing potential. That holds tremendous promise. But there is also the likelihood of increasing leverage (at still reasonable borrowing rates) in this business to go out and buy add-on businesses. And though PC sales have been weak, HP has still been able to maintain around 3% to 4% operating margins in this business.

It’s also important for investors to remember that there is a significant amount of cash flow and profits from consumables (printer ink) that will grow if HP can increase its installed base in any meaningful way. It enjoys operating margins in the 16% to 18% range, which is not bad at all. Perhaps a greater focus on this initiative will yield results after the split.

On the HP Enterprise side, M&A is almost a forgone conclusion in my mind. Perhaps a deal with EMC Corp. (NYSE: EMC) will finally get done. And there are many, many other options out there for HP Enterprise to build a more competitive enterprise/cloud business.

I think the two companies will see a marked improvement in cash flow, especially after restructuring costs wind down, which will help fund shareholder distributions and acquisitions.

What to Watch For

So what should investors look for in the coming months?

Next up will be HP’s third-quarter earnings results around August 20, followed by an analyst day in October. Both of these events will give management the opportunity to communicate directly with the market and answer questions regarding the split.

And then of course, the split should occur on Nov. 1. And if the stock doesn’t go anywhere by then I would expect the split to catalyze some positive momentum.

I reviewed data from Credit Suisse (NYSE: CS) on post-split stock performance for major spinoffs that occurred in the last decade. The research suggests that 87% of the split companies (they looked at 15 of them) outperform the S&P 500 over the 12 months following the split. The average outperformance was 9.3%.

Since announcing plans to split, shares of HP are down around 15%. That lack of performance surprises me. I think it signals that there remains a lot of skepticism surrounding HP’s ability to pull this major restructuring off. And it’s far from a foregone conclusion that the stock is going to rally.

But based on my analysis and the analysis of others that I respect, I think the market isn’t giving HP much credit. I think the upside of 50% over the next year is worth the risk. And I’m staying long HP. It might be worth considering doing the same.